Lloyds Banking Group took another 1 billion pound hit to compensate customers mis-sold loan insurance, taking its charge for the scandal to 5.3 billion and dragging it to a third-quarter loss.

But Britain's biggest retail bank on Thursday provided a more upbeat message on falling losses from loans that turn sour and said its cost-cutting programme was ahead of target.

Lloyds has reduced its loan book, cut costs and reined in bad debts as part of a recovery plan devised by Chief Executive Antonio Horta-Osorio to turn around the bank, which was bailed out in 2008 leaving Britain with a 40 percent stake.

Like other UK banks it has been saddled with multi-billion pound losses to cover wrongly sold insurance on mortgages and other loans, often to people whose circumstances meant they were barred from making claims.

But Lloyds said its bad debts this year were expected to fall to about 6 billion pounds, 1.2 billion less than it had expected at the start of the year. Bad-debt losses in the third quarter fell 35 percent from a year ago to 1.26 billion.

The bank said it is on track to cut costs to 10 billion pounds this year, down 1 billion from 2010 and two years ahead of target. It said it expects to cut its non-core assets by about 38 billion pounds this year, 13 billion more than it had planned at the start of the year.

"The group continues to perform well in a challenging environment and we are making significant progress against our strategy," Horta-Osorio told reporters on a conference call.

Lloyds also reported a pretax loss of 144 million pounds for the three months to the end of September, compared with a loss of 607 million a year earlier.

However, its underlying profit rose to 840 million pounds from 419 million a year before. That was ahead of forecasts which ranged from 419 million to 685 million according to a Reuters poll of three banks and brokerages.

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Lloyds had already set aside 4.3 billion pounds to repay customers wrongly sold payment protection insurance (PPI), far higher than rivals as it had the biggest share of the PPI market. Analysts had estimated it could set aside as much as 2.3 billion more.

Lloyds, which blames claims management companies for exacerbating the problem by submitting false claims, said it had paid out or spent 3.7 billion pounds on the issue by the end of September, or 70 percent of its provision.

Lloyds also made a 150 million pound provision in relation to German insurance business litigation, taking its charge for the issue to 325 million. It relates to claims in the German courts relating to policies issued by Clerical Medical Investment Group and sold by intermediaries, and follows German court decisions in July.

Shares in Lloyds were up 3.5 percent to 41.96 pence at 0800 GMT, outperforming a 0.5 percent rise in the European banking index, as progress in the bank's recovery plan overshadowed the increased cost of correcting past wrongdoing. The stock rose as high as 44.0p, its highest since August 2011.

"While the additional ... provisions are disappointing and there is a risk of still more to come, we believe the company is making excellent progress in improving performance in the underlying business," said analyst Gary Greenwood at brokerage Shore Capital.

Lloyds said it had incurred 731 million in costs this year related to disposals and measures forced on it by European regulators. The forced sale of 632 branches has cost it 611 million pounds.

(Editing by David Holmes)